Does the euro need Greece more than Greece needs the euro?

When the G20 finance ministers gather in Paris they face a stark fact: that nearly a year and a half since Greece received its first bailout, the crisis remains unresolved. Europe's leaders will be asked yet again what they are going to do with Greece.

...But there is another factor in all this, a wild card: the Greek people. It is just possible that the Greek people will have their say, that they will simply refuse to go along with austerity plans demanded by outsiders, their creditors.

What happens if a people simply says "no"? What happens if, through many small and not-so-small actions, they sabotage the plan?

I think of it like this: Greece and the core eurozone countries (Germany, France, etc.) are in the process of trying to apportion the additional costs of fixing the crisis. Is local austerity ("punishment" is a more accurate term in my opinion) going to be the main mechanism to pay for the solution, or will the crisis mainly be solved through direct assistance from Germany and France? So far the costs of this crisis have been mainly borne by the Greeks through austerity-punishment, but there's a limit to how much of that can be imposed. To better understand who will pay the additional costs of resolving this crisis, it's helpful to think about the incentives each side has to voluntarily shoulder the burden.

Greece

Yes, of course Greece has some awfully compelling reasons to try to avoid a unilateral default on its debt, and to shoulder some of the cost of avoiding that outcome. If at some point Greece is forced into unilateral default, it will face the prospect of losing all further financial assistance from the rest of the EU, a run on domestic banks and complete shutdown of its financial system, an immediate inability for the Greek government to pay all of its bills (even excluding interest payments), and a wave of Greek corporate bankruptcies. As I've argued before, I think that this would very quickly lead to Greece issuing its own domestic currency (which would probably operate in parallel with the euro rather than replacing it). And that would lead to rapid inflation, depreciation, and a drop in Greece's purchasing power. In a nutshell, the outcome for Greece would be very bad. So Greece undeniably has a strong incentive to comply with Germany's demands for continued austerity-punishment.

But keep in mind that once the trauma of unilateral default and the introduction of a new local currency has faded a bit, Greece could be in a very good position to stage a strong economic recovery. Argentina has pointed the way as far as that goes. So while that prospect doesn't mean that unilateral default would be a good outcome for Greece, it does mean that it's a dark cloud with a silver lining, and therefore a slightly less-bad option than it would otherwise be.

The Eurozone

But the outcome for the rest of the eurozone countries could be equally devastating. The main problem they face is that markets are looking to Greece for information about what the core eurozone countries are willing to do to keep the eurozone together. If Greece is allowed to unilaterally default, the markets will have their worst fears confirmed -- that the core countries are willing to allow other eurozone countries default and effectively exit. European financial markets will immediately be devastated by contagion as a massive selloff in Spanish and Italian debt quickly pushes weak eurozone banks to the brink of collapse. The eurozone will face the prospect of having to come up with perhaps in excess of a trillion euro to support the Spanish and Italian government debt markets and to rescue the entire European banking system from collapse.

It is difficult to overstate the seriousness of the crisis that would hit European financial markets in the wake of a unilateral Greek default, I think. This gives France and Germany an enormous incentive to bail out Greece -- for their own pure self interest.

If on the other hand the core eurozone countries actually do come through with sufficient funds to finally resolve the Greece issue, then all of a sudden markets will have important evidence that the core countries are indeed determined to do whatever is necessary to keep the eurozone whole. Put simply: if Germany is willing to pay up to keep Greece in the system, then it's pretty likely that it will also do what is necessary to keep Spain and Italy in the system. Investors' fears are soothed, and contagion largely goes away.

When Greece Hits its Limit

Given this, I would actually argue that the eurozone needs a Greek rescue more than Greece does. At some point soon -- if it hasn't already -- Greece is going to reach its limit regarding the austerity-punishment it is willing to accept. The Greek government will continue to miss deficit reduction goals set by the ECB and Germany, and will be unable to raise additional taxes or cut government spending further without the Greek people triggering the government's complete collapse. And given that this crisis is largely the result of forces beyond Greece's control, I wouldn't really blame them.

When that happens, Germany and France are going to have to think very, very carefully about their response. The immediate reaction of a lot of people at that point will be to throw Greece to the wolves. But if more sober heads prevail, the sort of reasoning I've outlined here suggests that it will be in the eurozone's own interest to swallow its pride and hand over whatever amount of money it takes to keep Greece in the system.

13 comments:

"So far the costs of crisis have been mainly borne by the Greeks through austerity-punishment"

I happen to disagree. The party in Greece and other countries was paid for to a large part by the real income reduction imposed on the German workforce since about a dozen years. The same applies for the bailouts in 2008 for banks, then for Greece and other countries, and now again for banks.

If you compare the development of the disposable income of the main street people in the eurozone countries since, say, 2001 and now, you might be surprised and even reconsider your opinion about who was and is the main loser in this transfer game. Hint: it is not the Greeks.

Argentina is a good comparator for a Greece which is allowed to refloat its own currency.

An equally good comparator is Iceland. Although they did not need to technically perform a sovereign default (the banks defaulted as they were nationalised), Iceland has powered ahead, allowing its currency to devalue down to its true market level. A quick (if deep) recession, and they are now in strong growth with their economy focused back on its traditional industries.

Greece, unfortunately, has eschewed the path of a quick, deep recession followed by strong growth. Sticking with a currency which is far to strong for its economy has resulted in far more unnecessary pain, all so that the German & French politicians can delay the day when they have to recapitalise their banks....

I have been arguing for the past 2-2,5 years (in my jurassic identiy) that an agressive restructuring with or without an exit from the eurozone, would be a better rational outcome for all parties.

Our problem is that our debt is out of hand; but our debt has been largely for consumption of German and French goods and services. Our politicians have been bribed, coerced or cajoled into agreeing to this, and we the poor slobs "would gladly buy a Porsche today and pay for it on Tuesday", if I may paraphrase Wimpy. You give poor people low rates in a hard currency, and a socialist government and they will stock up on everything they have been dreaming since they were 5.

Europe's problem is that it has refused for too long to accept some version of "lower of cost or market accounting" and while it realizes the loss it does not wish to register it on its books. If Europe could, it would eliminate double entry accounting.

Your conclusion is, I am afraid correct, in that our predicament is quite lousy in any scenario, and from a selfish point of view (and the benefit of hindsight) we should have unilaterally defaulted, forced a restructuring on our terms and kiss the euro goodbye, 2 tears ago. Instead we are trapped in "European" negotiations with countries that blame the ...rating agencies for their problems. Two years later, we are poorer, more confused and more demoralized. There are some of us who feel that may have been the plan, if you know what I mean.

THe eurozone cannot swallow its pride because there is no ...eurozone. If I was not Greek, I would be sneering.

PS Yes, we have a bloated public sector but it is not, per se, the problem. Its mismanagement is. Yes we have corrupt politicians but Siemens (et al) is their counterparty, and somehow the media are ...pro-Siemens. Yes we have a bizarre banking sector but it is the only "Greek" sector. Having said that, Greeks are hard working and they seem do be doing just fine once out of the local territorial waters. The tax evasion stories are ...one-sided. This is a country where tax laws have been changing weekly for the last zillion years.

The Germans and French are going to have to hand over money because an insignificant market for their goods can't really pay for them based on its own level of production. Because that makes more sense than dumping their goods in the mid-Atlantic rift for a similar real rate of return. And that market, wholly dependant on countries with real industrial bases for a supply of technologically advanced goods and on other countries for vitually all its energy needs is in less danger from a collapse in credit than the larger nations, because the complexities of the world of finance - nothing but symbolic 0's and 1's - can't be recast by the sovereign nations that have creatd that symbolic language to allow their real economies to produce and consume good. And of course the opposition of the citizens of those countries - a problem, not an argument, to technocrats like our host, who knows better than they do what would be good for them.

I agree - the best possible outcome would be a carefully managed default bringing Greek debt-to-GDP to less than 100%, with enough money for the Greeks to bailout their banks. Of course this will have to be paired with a re-capitalization of French and German banks.

Two problems with this that I see:1. Given the composition of Greek debt, it could require much more than a 50% haircut to get to a sustainable debt-to-GDP ration (http://www.zerohedge.com/news/ubs-kills-latest-european-bailout-proposal-why-50-haircut-greek-debt-will-not-work).

2. Other countries, especially Ireland and Portugal, but potentially even Italy, who also have debt-to-GDP over 100% could credibly demand the same option. Why should they pay all their debts when the Greeks get to write-off theirs?

Of course, every country that defaults increases the amount of bank capital needed, and increases the risk of contagion to others. The dynamics of contagion are especially hard to predict. The EFSF probably has enough capital to bailout the banks in the event of a Greek restructuring, but definitely not in the event of Greece, Ireland, and Portugal all demanding a restructuring.

And can we get past this crap that the Greeks/Spanish/Irish are not to blame for this crisis. Lenders may have been dumb in their underwriting, but that doesn't absolve borrowers - http://shamirkarkal.blogspot.com/2011/10/neither-borrower-nor-lender-be.html

<span>Greece has enough assets to reduce its seovereign debt by half, from 160% debt to gdp to some 80%. these assets could be put in a safe european account for orderly management and sale, get the immediate payment in cash and come back to the markets to borrow with a reasonsable debt to gdp levels without ever needing to restructure its debt nor to default. this would be a win-win situation for both the greeks and the europeans of the EZ.</span>

Well, and there are also some hidden costs to be calculated. For example, recently in Italy there were violent actions during a public manifestation. Those violent actions were performed as a kind of organized urban guerrilla and it seems that the Italians behind those actions have been trained in Greece where violence is escalating! Well, how much do things like these cost?

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The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)